By Robert Paterson, analyst, Morgan Stanley Dean Witter, London office
Two significant proposals have recently been published that may affect spreads in the Sterling securitisation market. Firstly, Paul Myners made public his recommendations in relation to the Minimum Funding Requirement (MFR) in a letter addressed to the Treasury and the Department of Social Security (DSS). Secondly, and perhaps more importantly, the UK Accounting Standards Board informally approved Financial Reporting Exposure Draft 20 (FRED 20).
Paul Myners, the Chairman of Gartmore International, was commissioned by the Treasury to investigate a wide remit of issues in relation to institutional investment. Whilst Myners' full review is not due to be published until March 2001, last week saw the publication of a letter from him to the Treasury and the DSS which covered his recommendations on the MFR and proposals for change in relation to the law on investment in limited partnerships.
The publication of the letter was designed to coincide with the consultation period - which runs until January 2001 - for a paper published by the DSS1 in September with regards to the MFR. His recommendations differ from the DSS report in that he favours scrapping MFR altogether. By way of "replacement" for MFR, Myners calls for more disclosure and transparency on the part of pension fund trustees regarding their investment decisions to the extent they should stand up to external scrutiny through the publication of a Transparency Statement. This would provide details of asset allocation and assumed rates of return. The report makes no specific recommendation on the way fund liabilities should be valued, and although this is less bond friendly than the DSS proposal, we believe that it is in the long term positive for spread product. This is because a move away from being tied to investing in gilts would lead more fund managers to invest in credit product, and hence be positive for credit spreads.
The implication of any change to the MFR will depend on what the DSS and Treasury decide to do. In the event they wish to scrap the MFR, this will necessitate an Act of Parliament, whereas if they wish to merely adjust MFR, the changes - depending on their nature - could be made through regulation. As there is no time allocated for this topic in this Parliamentary session, which is due to end by summer 2001, any change that requires an Act of Parliament is unlikely for some time.
In our view, a more significant issue for the Sterling securitisation market is FRED 20. The UK Accounting Standards Board have informally approved Financial Reporting Exposure Draft 20 ("FRED 20") and we believe that formal approval is likely next month2. FRED 20 proposes a re-think on the accounting for pension fund surpluses and shortfalls. By proposing pension fund surpluses and shortfalls be included on balance sheet, and that liabilities should be discounted at a AA corporate bond index yield, the accounting standards will encourage corporate pension funds to:
*move from defined benefit to defined contribution schemes;
*sell equities and buy fixed income; and
*sell gilts and buy Sterling corporate debt.
The long-term trends in pension fund management appear to be pushing investors towards fixed income products in three ways. Firstly, as the proportion of retired members within pension funds grows, fund managers will be encouraged to hold a higher proportion of their investments in bonds.
Secondly, if approved, FRED 20 will also be positive for fixed income products and especially highly rated debt, given the potential adoption of a AA index discount rate. The marking to market of pension fund surpluses and shortfalls within corporate balance sheets will also encourage companies which retain defined benefit schemes to move to fixed income products in order to reduce volatility in their balance sheets. Finally, allowing pension funds greater latitude in their investment options would be positive for credit spread product.
With these trends all pushing investors towards fixed income credit products, we believe the longer term outlook is positive for Sterling spread product. In this sense we believe that, albeit through different routes, all roads lead to Rome.
1 See Morgan Stanley Dean Witter Securitised Products Group Research, "MFR Proposal Bullish for Sterling ABS," European Securitised Perspectives, 18th September 2000.
2 See Morgan Stanley Dean Witter Fixed Income Research, "FRED 20 Informally Approved," 3rd November 2000.